New Keynesian Economics

New Keynesian economics emerged in the 1980s as a response to both Classical and New classical economics, incorporating microeconomic foundations into Keynesian macroeconomics. It addresses market imperfections and explains why economies do not always self-correct quickly, justifying government intervention in some cases.

Key Principles of New Keynesian Economics

1. Price and Wage Stickiness
   • Unlike classical models where prices adjust instantly, New Keynesian models show that prices and wages are "sticky" due to contracts, menu costs, and norms.
   • This rigidity means markets take time to clear, leading to unemployment and output fluctuations.
2. Imperfect Competition
   • New Keynesians challenge the assumption of perfectly competitive markets, arguing that firms have pricing power (e.g., monopolistic competition).
   • This explains why firms don’t always lower prices during recessions.
3. Rational Expectations but Market Failures
   • Unlike traditional Keynesianism, New Keynesians accept rational expectations (agents anticipate policies), but emphasize that market failures prevent efficient outcomes.
4. Role of Monetary and Fiscal Policy
   • Because markets don’t always adjust quickly, monetary and fiscal policies (interest rate changes, government spending) can help stabilize the economy.

Criticism of New Keynesian Economics

• Too much reliance on microfoundations – Some argue it overcomplicates Keynesian insights.
• Limited real-world price stickiness – Critics suggest firms adapt more than models predict.
• Still assumes rational behavior – Unlike behavioral economics, it doesn’t fully address irrational market behavior.